Interest Rate Risk Management

Interest Rate Risk Management

Overview z

Managing interest rate risk z Principles for establishing a conducive interest rate risk management environment. environment z Operating a sound interest rate management process

Managing g g Interest Rate Risk

Introduction z

Interest rate risk management is mainly hi d on repositioning hinged iti i the th strategic t t i gap to t desired levels. z This can be done in broadly 3 ways, y; namely; z 1) Pricing strategy z 2) Asset-Liability Asset Liability restructuring z 3) Derivative strategy

Introduction z

For strategic reasons, the gap repositioning would be done, typically, within the context p change g in interest rates. of the expected z The following broad strategy can be used;

Current Position Asset sensitive iti book

Liability sensitive book

E[IR] Movement

Strategic Move

U Upward d

A Approach h li limit it

Downward

Reduce gap/switch to liability sensitive b k book

Upward

Reduce g gap/switch p to liability sensitive book

D Downward d

A Approach h li limit it

Introduction z

Thus the strategies can be broadly classified into 2: 1) Strategies where we are approaching asset sensitive gap limit 2)) Strategies i where h we are approaching hi liability sensitive gap limit.

Pricing Strategy z

1) Strategies which contribute to approaching hi the th liability li bilit sensitive iti gap limit li it include: z Making interest rates on short term deposits g term more attractive relative to long deposits z Increasing the interest rate on long term loans.

Pricing Strategy z

Strategies which contribute to approaching the asset sensitive gap limit include: 1) Making interest rates on short term deposits less attractive relative to long term deposits. 2)) Loans on long l term loans l to be b re-priced i d more regularly.

Pricing Strategy z

The ability to implement the pricing strategy will mainly depend on: 1) the interest rate elasticity of demand for the assets and liabilities. 2)) the h value l and d number b off positions ii that h the h financial institution has ability to change the interest rate.

Volume Strategy z

The relatively fastest way of repositioning a gap is through purchasing and / or selling th required the i d amountt off assets. t z The strategy of approaching the liability sensitive i i gap limit li i would ld generally ll involve i l purchasing more longer term instruments and less short term instruments. instruments z The strategy of approaching an asset sensitive iti gap limit li it would ld generally ll involve i l purchasing more shorter term instruments and less long term instruments. instruments

Derivative Strategy z

z z

Instead of repositioning the gap, hedging against adverse d movements in i interest i rates can be b done d through interest rate derivatives. The most common types of derivative instruments used in developed financial markets include: Forward rate agreements: These are contracts traded over-the-counter that a certain rate will apply to a certain principal during a specified future pperiod of time.

Derivative Strategy z

z

z

Interest rate futures: These are standardized f forward d contracts that h are traded d d on a derivative d i i exchange. Interest rate swaps: These are contracts where 2 parties agree to exchange interest payments ONLY on the same principal amount. As no p principal p is exchanged, g , the size and composition of the balance sheet of the 2 parties remains unchanged. g

Derivative Strategy z

z

z

Suppose we have a liability sensitive gap and we anticipate an increase in interest rates. rates Instead of adjusting the gap, we buy a swap where we agree to pay the other party a fixed interest rate. rate If interest rates indeed increase, we get a net positive payment from the swap deal which will offset the decline in net interest income. If interest rates however decline, decline we make a net positive payment on the swap deal , which will offset an increase in net interest income.

Derivative Strategy z

z

z

Suppose we have an asset sensitive gap and we anticipate a decrease in interest rates. rates Instead of adjusting the gap, we buy a swap where we agree to pay the other party a variable interest rate. rate If interest rates indeed decrease, we get a net positive payment from the swap deal which will offset the decline in net interest income. If interest rates however increase, increase we make a net positive payment on the swap deal , which will offset an increase in net interest income.

Principles for establishing a conducive interest rate risk management environment.

Principle 1 z

The board of directors should have overall responsibility for approving policies and strategies g to be used to manage g interest rate risk.

Principle 2 z

Senior management has the responsibility of: f – developing the policies and procedures for

identifying, id if i measuring, i monitoring i i andd controlling interest rate risk – ensuring i that h the h strategies i andd policies li i usedd to manage interest rate risk are appropriate and effective. effective z

Principle 3 z

FI’s should identify the interest rate risk inherent in new products and activities and ensure that these are subject j to controls and adequate procedures before being introduced or undertaken. undertaken z Major hedging or risk management activities should first be approved in advance byy the board.

Operating O ti A Sound S d IInterest t t Rate Risk Management Process

Principle 1 z

FIs should CLEARLY define the individuals and / or committees responsible g g interest rate risk. for managing z The management of interest rate function should be clearly independent from the position taking functions of the financial institution.

Principle 2 z

The analysis and interest risk management activities should be delegated to competent g and/or staff with the technical knowledge experience consistent with the nature and scope of the FIs FIs’ activities. activities

Principle 3 z

FIs must have information systems that capture all the material sources of interest rate risk. z The assumptions underlying the system should be clearly understood by management.

Principle 4 z

FIs must establish and enforce operating li it and limits d other th practices ti th t maintain that i t i exposures within levels consistent with their i internal l policies. li i z Such limits should be appropriate pp p to the size, complexity, and equity of the FI. z Limits can be set on individuals, individuals business units, portfolios or instrument types.

Principle 5 z

FIs should use stress testing when setting or reviewing limits and policies.

Principle 6 z

Interest rate risk reporting should be timely and should be provided to the board of directors and management. directors, management z The basic structure of the reports should include the following information; z 1) Summary of aggregate interest rate exposures z 2) Report on compliance with limits and p policies. z 3) Results on stress tests

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